Cost Flow Assumptions regarding inventories (2014)Apunte Español
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COST FLOW ASSUMPTIONS REGARDING INVENTORIES
Carla Martínez González U83192 - IBE
Dealing with the value of the inventories that a company or enterprise works with is not easy.
Through the years, a lot of different methods have been developed with that purpose.
The main intention of this essay is to present a clear analysis about the most important methods used in accounting in relation with inventories.
There exists an accounting method known as FIFO.
The name represents an acronym of: First in, First Out. The expression itself introduces a brief idea of the concept. Basically, it consists in selling the oldest inventory first. It is properly used when we take into account different batches of the same article.
During periods of inflation is commonly used as it can be seen as an increase of the value of the inventory. As costs of these inventories are so much lower than the market prices, in the end it leads to higher benefits for the company.
At the same time, there also exists a method known as LIFO: Last in, First Out. This accounting procedure consists on taking out of the inventory first the last entries. As a consequence, the cost of the last inventories acquired would be the same as the cost of the first inventories sold so it could represent a reduction in the amount of taxes to pay (assuming that we are in an economy which registers continuous and periodic increases in prices). That is the main reason why the PGC of 2008 doesn’t admit this method.
Until this point we have analyzed how to valuate inventories taking as a basis the first or the last entries. From now on we would analyze how to valuate inventories making averages of their costs. It’s important to highlight that when we talk about averages or any other concepts we refer to butches of the same product or article.
When using the average method we found that there are several subtypes. In the end they provide us a value for the ending inventory cost.
First of all there is a method known as Weighted Average Cost. It consists on dividing the cost of goods for selling by the total amount of goods (initial inventories + purchases of goods) which gives us an average cost per unit. It requires an ending physical count to, in the end, multiply this quantity by the value to get an estimation of the inventory cost.
Also, another method related to averages which is used, is known as Moving-Average Cost. To valuate the inventories through this method, data about the physical count of the inventory and its 1 COST FLOW ASSUMPTIONS REGARDING INVENTORIES Carla Martínez González U83192 - IBE initial value is needed. The procedure would be the following: every time a purchase is made, the costs incurred are added to the initial inventory cost and we get a new average value for the cost of the inventory.
These methods are commonly used in manufacturing companies or when firms have to deal with goods which cannot be easily differentiated. One of the most important advantages of these methods is that they are not really expensive to compute, as they require a little effort, so in the end they lead to a reduction of costs. At the same time, if the market in which the firm works experiences an upward or downward trend in costs, the average method does not provide a realistic valuation of the inventory.
Another way of computing the value of inventories totally different from Average Cost would be the Specific Identification Inventory valuation method. This method is only applicable when items can be easily identified and it requires a detailed physical count. Basically it relates the inventory items with the price they costed. I personally think this is one of the best tracking methods as it is the most accurate. But at the same time is rarely used among companies as usually is very difficult to identify items, and it would lead to high costs when dealing with huge inventories. This method is commonly used in art galleries, jewelry, etc… Is also needed to add that this method can be easily manipulated by management as it can report a lower income to reduce the amount of taxes payable.
Once the most important methods have been analyzed is easy for me to highlight that depending on the type of inventories a company deals with and the economy in which it works it would be more profitable to use one accounting method or another. In my opinion, methods like LIFO or FIFO could present a distorted image of the value of the inventory which is not positive at all. At the same time methods like the Average Cost would be fairer but wouldn’t also represent an accurate valuation of the inventory when dealing with inflation. For me the best accounting method would be the Specific Identification as it valuates each butch of the inventory at the price it was acquired but it seems to incur high costs, not only the information cost of classifying all the items but also the monitoring costs of controlling management (not to manipulate the valuation).
So, in the end it’s extremely difficult to choose an accurate and fully-reliable valuation method.